Oil to Follow Gold's Lead

We’ve gotten a pretty stunning rally since the Brexit vote. It seems like forever ago, but the S&P 500 hit 2,000 just 11 days ago. The rally started 10 days ago, and the S&P 500 has added 7.5% in that time. Pretty impressive, and we haven’t seen a move like that since December 2011. 

Since the lows back in February, the S&P 500 has rallied 17%. That’s also pretty good. But it’s nowhere near as good as the rally one of the most hated commodities in the world has put together…

This commodity — plagued by oversupply and crashing prices — has just about doubled in price since those February 11 lows. 

No, it’s not gold. Sure, some gold stocks have rallied hundreds of percentage points higher. Barrick Gold (NYSE: ABX) started the year around $7 a share. Its recent high was over $23, better than a 200% advance off the lows. 

But gold itself has rallied around 25% this year. 

Here’s a chart, complete with prices, that may help…

Oh, whoops, that chart tells you it’s oil right at the top. So, yeah, I’m talking about oil. It’s doubled from its lows earlier this year. Because the inevitability of a rebound was built into the oversupply that caused the price crash in the first place. 

When a product gets oversupplied on the market, two things happen: One, demand for the product rises. And two, the price falls. These two outcomes work together.

When there’s a hot new product out that people want, companies will scramble to make more of that product. As more entrants come into the market, there will eventually be more of the product than people want. So suppliers will cut prices to attract buyers. Some suppliers won’t be able to afford to cut prices and will simply exit the market. 

But then as the price falls, people think, “Hey, since it’s cheaper, I’ll buy more,” and demand for the product goes up. And the whole cycle can start over again. 

These two forces — supply and demand — reinforce each other and work in cycles. Periods of excess turn to periods of shortage and so on…

But there are cycles, and then there are CYCLES. 

And as we’re going to find out, this oil cycle could get really wacky…

Can This End Well?

The widespread use of fracking to get at nonconventional oil (sometimes called shale or tight oil) here in the U.S. really started picking up steam in late 2009. By the end of that year, the U.S. was pumping 5.3 million barrels of oil a day. U.S. production peaked last year at 9.4 million barrels a day. 

It took six years for U.S. oil producers to add 4 million barrels a day to total production. Obviously, with oil at $100 and producers able to make $30–$40 a barrel, there was plenty of incentive to ramp production. 

Of course, what happened next is pretty well known. The Saudis ramped production, and prices got creamed from the oversupply. Somewhere around 70 U.S. oil producers have declared bankruptcy. Exposure to energy loans has pushed banks lower. Default rates on high-yield energy bonds have been soaring. And earnings for energy companies have been so bad, they’ve dragged earnings for the entire S&P 500 down…

Many of these factors contributed to the 12% correction we got earlier this year. All in all, it’s remarkable how widespread the damage from falling oil prices has been. 

But we are seeing two very predictable responses to lower oil prices: demand is going up — people are driving more. And production levels are falling. 

In just the last week of June, U.S. oil production fell by 194,000 barrels a day. Total daily production is now down around 1 million barrels, to 8.4 million a day. 

Global oil consumption was 92.45 million barrels per day in 2014 and 93.85 million barrels per day in 2015. This year, demand will rise to 95.29 million barrels per day, and next year, 2017, the forecast is 96.78 million barrels per day. Annual demand is rising about 1 million barrels a day. 

Whatever, the numbers are what they are — the point is that demand is rising. And while production is falling here in the U.S. and in countries like Venezuela and Nigeria, it’s rising in Russia and Iran. So let’s call it a wash. Production is steady and demand is rising…

Why Haven’t Oil Stocks Rallied?

As I observed earlier, gold stocks have rallied hard as gold prices themselves have made a modest gain. But oil stocks haven’t rallied that much, even though oil prices have doubled from their lows earlier this year. Why not?

And what’s more: why, exactly, has oil rallied when there’s still a massive glut of oil on the market?

I think Wall Street is doing a great job of making sure that oil stocks continue to look like a terrible investment right now. 2017 earnings estimates for U.S. producers are not good at all — massive per-share losses are expected.

This is true; even the EIA is forecasting stronger oil prices going forward. They say West Texas crude will average $52 a barrel next year. And I’ve seen estimates as highs as $65 for next year.

So what gives? Why the optimism for oil itself but pessimism for oil stocks? 

You know how this game is played. Wall Street loads up while they tell you not to. And then they make the big money while you chase oil stocks higher.

As Warren Buffett said, be greedy when others are fearful. That applies to oil stocks right now. And if you want my top pick, it’s Oasis Petroleum (NYSE: OAS), currently trading around $9 a share. 

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.